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« Last post by galumay on August 13, 2022, 01:45:39 PM »
cont from above....
Idea Sourcing
I would say that my best investments are typically situations that actually screen quite poorly. These companies are not only ignored by most investors for being small and illiquid, but the opportunity tends not to be readily apparent with a cursory glance at their past financials.
I should be clear. I�ve never invested pre-revenue and very rarely invested without positive cash flow. I leave that to venture capitalists and people much smarter than me. What I�m talking about are established, sustainable businesses with positive trends available for all to see that are simply masked in their current financials. This can be caused by an R&D project, or legal costs, or goodwill amortization from recent M&A, or really any number of short-term factors. It�s often just a business with relatively high fixed costs that has recently reached an inflection point of scale. Operating leverage can be vastly underappreciated in its early stages.
I would say I�ve had the most success in businesses where declines in one segment or product have been offsetting another. Take a multi-segment business with vastly different growth or margin profiles. Or, even better, combine the two. You have a high margin product in decline and a lower margin product in growth. So for a number of years the top line is flat and blended margins decline. Sounds horrible and is excluded from nearly any screen. Probably trades pretty cheap, right? But these can be very simple situations to analyze. You don�t need to run a DCF to realize that the higher margin product can�t decline forever. Give it a zero and analyze the other segment on a standalone basis for what it is. Then it�s just a matter of time horizon.
Buffett likes to say it's very hard to know WHEN something will happen and it's very easy to know WHAT will happen. I think I often see opportunities present themselves simply because other market participants are waiting around for the WHEN, the catalyst if you will, whereas the ultimate WHAT is actually quite clear.
I�ve sometimes described what I do as making decisions with incomplete information. It�s not always going to be obvious, but it doesn�t have to be. People usually think of the investing profession as one of rigorous mathematics and statistics and precise analysis. The reality is that what I do is more about possibility and probability. The range of possibilities is typically so wide that I can't render an actionable decision. These go in my "too hard pile" if you will. But I�ve looked at thousands of companies and only invested in dozens, so you can afford to dismiss 99% of the ideas that come across your desk.
I should emphasize that I rarely feel compelled to find a new actionable idea. You let them come to you on their own timeline. As Buffett has said, and this may unfortunately be the only way in which my mind works similar to his, my decision-making acuity fades with lots of cash. There is a compulsion to do something with a bunch of cash sitting around. So, I try to operate with very little cash so that the threshold for a new opportunity must always be greater than an existing one. I�m admittedly less nimble this way, but a lack of liquidity also reinforces a long-term focus.
Long Term Focus
I often hear people talk about long-term investing and the difficulty of holding through the drawdowns. I don't know the stats, but I've seen the number of 20% or is it even 50% drawdowns in Amazon and others, and how so few investors had the conviction to hold through such periods. Frankly if an asset appreciates 10x and then falls 20% I'm not sure why anyone would panic.
Personally I find the bigger challenge is to hold through the good times, the really good times. I guess it's kind of hip in long-term investing circles, particularly with microcaps, to talk about how one only invests in opportunities to 3x, 5x, 10x their money, and we might scoff at those lowly 20% or 50% opportunities. And that's great until one sells out six months later with a 50% gain because the stock "got ahead of itself.� I used to do this all the time and suffered great opportunity cost for it. I'd do all the research to identify a long-term opportunity and then turn it into a short-term trade.
I�ll give you an example. I owned a company XPEL, a maker of protective films primarily for automotive applications. It became a rather popular microcap, now a $2 billion smallcap, and was actually my largest position for a number of years. I owned it at 50 cents and I owned it at 50 dollars. Hey, my first 100 bagger, right? But I sure didn't make 100 times my money on it. My thesis was long-term but I let trading get in the way of compounding. Constantly trimming and adding with some ridiculous assessment of fair value and expected IRR.
Look, I'm not suggesting there's only one way to make money. Plenty of people make stellar returns flipping assets for 10 and 20% gains, and that's great if you have a constant funnel of such opportunities. But to limit your investing universe to long-term compounders and then cut the ride short, well that just can't be the ideal strategy. I guess in a perfect world, long-term compounders would appreciate at the same rate as one's assessment of their fair value. The valuation would never "get ahead of itself" and you could sit back and comfortably hold through years of compounding. Unfortunately that's never been my experience.
I have a thought exercise I like to do. And this may be the only original investing thought I have to share with you today. Before I buy anything new, or add to an existing position, I ask myself -- if this security goes up 30% or 50% next month on no fundamental change, would I consider myself lucky and sell? If I would sell on a 50% gain, I would never hold it to 5x or 10x, so I don't buy no matter how optimistic I am about the company's long-term prospects. The very fact that I would run to the exit for a quick gain tells me I don't have the conviction to hold this asset. That simple thought experiment has dramatically reduced portfolio turnover because I limit myself to long-term ideas of the highest conviction. Then I can happily ignore short-term volatility to both the upside and downside.
Evolution of Strategy
There's something rather humbling about the investing game. I guess I�ve had a decent track record but I still always look back at what I was doing just a few years ago and cringe at my analysis and my decision making. I'm not very active on Twitter but a couple months back posted a complete list of every stock I've owned over the past 20 years, and that was a reminder of some painful experiences in there. But hey, what's the saying, experience is what you get when you don't get what you want, right? I would like to think I won't make the same bad decisions again in the future, but I'm sure I'll find some new ones.
Perhaps the most positive development I've made is simply reducing the sheer quantity of decisions. I would previously make several new investments every year but now I'll go years at a time without a change. I've really tried to restructure my investing processes to create a bias toward inactivity. And that inactivity suits my lifestyle and goals. There are many ways to make money investing or trading that require that one spend 12 hours a day at their Bloomberg terminal, and that's great if someone enjoys it for the activity in and of itself. But I know for me I want investing to be just one of many areas where I can to choose to spend my time, and I think I've settled on an approach I'm well suited to. And as Buffett says, when there is nothing to do, do nothing. Investing is unique that way. You don't get paid for activity or effort. You ultimately just have to be right.
Macro Concerns
Well, no one buys or sells a farm based on whether they think it�s going to rain next year. Sound familiar? I'm really not too worried about the economic cycle.
Before I invest in any business I ask myself not only can this business withstand an eventual recession, but is it managed in such a way that it will come out in a stronger competitive position than it went in. When investing for the long-term you have to expect to go through the lows of the cycle. That should be self-evident really.
That being said, I don't generally invest in highly cyclical industries. I got my start investing in 2002 and for the first decade the vast majority of my capital was in railroads. There's a cyclical industry I understood fairly well, and it was still unloved by Wall Street in those years prior to Buffett buying BNSF. That said, I would not touch the railcar builders of the time -- Freightcar America, Greenbrier, American Railcar. Lots of money was made there, and lots of money was lost, but they were no place for long-term investment through the market cycles.
I would put most macro questions � the future of interest rates, inflation, geopolitics, energy prices, foreign exchange � sure they�re all important in one way or another, but they�re simply unknowable. I look for businesses that can thrive in any reasonably foreseeable environment. Certain industries require macroeconomic opinions. I never really have an opinion so I can't participate.
Risk & Diversification
There�s a Howard Marks quote I love. Never forget the fate of the six foot tall man that drowned crossing the river that was five feet deep on average.
We can't live on averages. We must survive the extremes. Put another way, a long string of large numbers multiplied by a single zero is always zero. You simply can't allow a single failure to knock you out of the game. But, that threshold is completely different for different people. This is why any universal asset allocation theory is academic nonsense.
Most people, and by that I mean non-investors, should probably own an index because they would have no sound basis by which to rank their 1st, 10th, or even 100th best idea. Some casual investors may own a diversified portfolio because they can find a couple dozen good ideas but don�t have any unique insights in which to differentiate one from another. There�s nothing wrong with admitting that. What�s the saying? There�s only two kinds of people that lose money -- those who know nothing and those who know everything. Just respect what you know and recognize whether or not you have differential insight.
In my case, largely in illiquid microcaps, my investable universe is quite small so my number of positions is also quite small. But I sleep well at night knowing that if any individual position goes to zero it won't take me out of the game or impact my lifestyle or future opportunities. Beyond that, I really don�t believe in any fixed allocation limits. There have been a handful of times over 20 years where I�ve purchased a 30% position at-cost. For some that would be unthinkable. Others would be fine with 30% but would quickly trim if it appreciated into 40% or 50%. I must say I disagree with this concept of automatic trimming. Sales should be based on fundamental changes, or valuation changes, or new opportunities, not arbitrary portfolio limits. If you purchase a 30% position and could have survived on the other 70% of your portfolio if it went to zero, what changed simply because your top position outperformed the rest? Isn�t that what you wanted? I guess I find it helpful to think more in absolute dollar terms rather than percentages when considering risk.
I do want to add one caution that I learned the hard way early on. It�s very easy to start micromanaging a portfolio based on variations in expected returns. I see people with spreadsheets of their investments and target prices and IRRs for each. A stock moves up from $10 to $15 and suddenly the expected return to their $30 target drops from 200% to 100%, so they sell and reallocate into another that they expect to return 150% or 200%. This comes back to what I said before. You have to know your game. If your objective is long-term compounding, you probably shouldn�t view a stock at $15 so differently than you did at $10. In an attempt to maximize IRR in a spreadsheet, you may very quickly end up with a portfolio filled with your weakest recent performers.
Commonly Accepted Wisdom You Disagree With
That there�s a positive correlation between �risk� and return. I�ll blatantly plagiarize Howard Marks here. Risk simply means that more things can happen than will happen. If a risky asset could be counted on to deliver high returns, it wouldn't be risky.
Cryptocurrency
I�m sure you know far more about this than I do. I�ve always wondered how, even if you believe in the premise and technology, you can pick the long-term winner? Bitcoin? Ethereum? What�s the Elon dog thing? Dogecoin? I�m already showing my ignorance here.
It�s certainly working out well for the believers thus far. But I�m reminded of Charlie Munger�s reaction. If you jump out the window of the 42nd floor and you�re still doing well when you pass the 20th, it doesn�t mean you don�t still have a problem.
Seriously, though, I have no opinion on this.
Favorite Quote
Haven�t I been quoting Buffett and Munger all hour? I guess I�ll go with Mark Twain. It's not what you don't know that gets you into trouble. It's what you know for sure that just ain't so.
Overconfidence and confirmation bias are always a danger.
Investor You Want To Meet
Buffett, Munger, Marks? I don�t know. They all significantly shaped my investment philosophy, but have also been interviewed by such talent that I can't imagine what I would ask that they haven't already publicly answered.
Tony Deden of Edelweiss Holdings, an investment manager in Switzerland interviewed by Grant Williams a few years back for, what was it, RealVision. It's still available on YouTube in fact, and they later recorded a second part that aired on Grant's podcast. To be clear, our execution couldn't be more different. His focus on endurance above all else. He has a very large position in gold. Even the fact that he's managing vast family fortunes while I cringe at the very notion of intergenerational dynastic wealth. But his self reflection and thoughtfulness of process really resonated with me. Not to mention his way with his words, a gift I lack but envy. He could answer any question with vivid illustration. So, yes, I would have much to ask Tony Deden.
Interview with Twitter @TheLazyBeavers, July 2022
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